I’m an investor with New Atlantic Ventures, where I help launch early-stage companies that have new technologies and new takes on how to win in business. I’m inspired every time entrepreneurs prove there’s a better way to solve big problems, make life better or disrupt comfy clubs. I'm skeptical, however, when start-ups get too trendy or raise too much money before the business is proven. Before becoming an investor, I had a great run building Boston Consulting Group’s Technology, Media, and Telecommunications Practice. Away from work, I ski, mess around in boats, spoil my grandchildren, and tinker with digital toys.

Budget, or Fudge-It?

Now is the season of the annual budget: it starts in November, and in the tough cases, the budget is not settled until January or February. There is always negotiation between management and the board: how high targets should be, how much it will cost.

Why do we do budgets? I see two main values: resource allocation, and a agreement on performance expectations.

The budget describes how the company will allocate its resources among functions and programs: what products do we develop? What markets to we try to enter and grow? This is obviously vital.

The budget also influences how investors allocate resources. It determines the “burn rate” (rate of cash consumption). It tells you how far the company is from cashflow breakeven, and hence gives an indication of how much money will be needed to get there. It tells you how much revenue is expected, which indicates the state of development of the business, and is a good proxy for enterprise value. A bullish budget encourages investors to write checks.

Performance expectations are the heart of the contract between management, the board, and investors. For the typical early stage company, the contract says: if you let me burn $X million of cash, I can achieve these objectives: products launched, customers acquired, revenue and margin rate, progress towards break-even, etc. Management incentives, such as cash bonus or extra stock awards, are often tied to the budget. Probably the most important thing is management credibility. If the management performs to budget, or at least comes close, then the next time it asks for more money, promising further results, it has cred. Investors, new and old, are more likely to step up.

I’ve got two companies in my portfolio that have already (by February 15) declared a big miss on the key parameter of their 2013 budgets: net cash burn. One missed mostly on the revenue side, the other mostly on the spending side. What does that mean?

Revenue misses happen all the time. Early stage companies set aggressive, visionary targets, and they usually don’t hit them. If an early-stage company regularly exceeds its revenue budget, I get very excited, because it tells me that they have found a rich and easily mined seam in the market.* If they hit 80% of revenue target, I’m probably pleased. Obviously, results well south of that are cause for concern. The company that now says it is going to miss its revenue raised money in Q4 of last year, however, so there is credibility question here. How did they not know three months ago that this would happen? They are working hard to show that the problem came from a complex dynamic created by a mix shift in the business that they had never seen before, and hence it was a surprise.

A big spending miss is another thing entirely. Good CEOs/CFOs at early stage (and really any stage) know exactly where they are with cash at all times, and what the options are to dial spend rate up or down in response changes in cash flow. A big spending surprise in a short period of time is big trouble: how did they not know three months ago that it would be imperative to spend this money? Was the budget they gave us competently prepared and truthful? And corrective action on spending, if taken mid-year, does more harm and less good than right-sizing from the start. Unexpected things can happen: lawsuits, fires, system outages. Barring this kind of force majeure, investors expect management teams to be on top of spending.

The budget is fundamentally the most important formal communication between management, the board, and investors. It’s fine to be aggressive; that’s expected. It’s a real mistake to be sloppy or misleading, especially on the things you can control. In the end it’s about credibility, and once a management team loses cred, it’s hard work to come back.

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*BTW, this is opposite for more-mature companies: resources are less scarce, and revenue forecasting is more about bonus targets than access to financing. You have to watch for “sand-bagging” the revenue forecast followed by glorious overachievement to bring down a nice bonus.

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